How We Think Investment Costs Work
When I first started investing twenty years ago I had no clue what I was doing. I had, however, read enough to know that it was important to keep investment costs low. I remember looking at a list of mutual funds I was considering investing in. One of the things I looked at was the expense ratio.
I eventually found a fund that looked intriguing with an expense ratio of 1%. Many funds in my list had higher expense ratios, and some lower. I wasn’t sure exactly what an expense ratio was, or how it worked, but 1% seemed like such a low number I couldn’t really imagine it hurting me much. I remember thinking that I would probably have to pay 1% of whatever gain I made during the year, which seemed more than reasonable to me.
At the end of the year I looked at my statement and tried to find where the costs had been deducted from my account, but I didn’t see anything. I then started looking for a bill in the mail asking me to pay my 1%, but it never came.
I eventually forgot all about the expense ratio, which is exactly what the investment company hoped would happen. I never thought of investment costs again until several years later when I learned how expense ratios really work. In talking to other investors over the years I have found that my initial misconceptions about investment costs are not unusual.
How Investment Costs Really Work: 1% of What?
Since my early years of investing I have learned the truth about expense ratios. The expense ratio doesn’t refer to how much you pay of your investment gain for the year, but how much you pay of the total amount you have invested in the fund.
For example, if you start the year with $100,000 invested in a fund with a 1% expense ratio, and the fund gains 10% for the year, you would end the year with $110,000 in your account before expenses. The 1% expense ratio is not calculated on your $10,000 gain, which would be $100 ($10,000 x .01). Instead, it is calculated on the average amount in your account during the year, making your expenses approximately $1,050 ($105,000 x .01).
Why do mutual fund companies calculate expenses like this? I can think of two great reasons from their perspective:
- It allows them to report very small expense ratios that seem harmless and insignificant
- They get paid whether you make any money or not
And how are these expenses paid? You will never get a bill for the $1,050 or see the costs deducted from your account in monthly statements. Instead, 1% of assets under management (AUM) will be quietly taken out of the fund throughout the year becoming an invisible drag on the fund’s performance. In the example above, your fund would not report to you a 10% gain for the year, but a 9% gain, and the amount in your account at the end of the year would not be $110,000, but slightly less than $109,000.
Although there are disclosure laws mutual fund companies have to comply with the companies do their best to make investment expenses hard to understand and invisible. Their hope is that you will allow them to continue quietly taking the expenses out of your account without giving it a second thought. Now that you are armed with the knowledge of how investment costs really work I trust that you will not let that happen.
In the words of Jonathan Clements, financial author and journalist, “Performance comes and goes. Expenses are forever.”
Now that you understand how investment costs really work do not let them remain invisible. It is time to shine some light on them and learn exactly how much you are paying in investment costs.
- Determine the expense ratio of each of the funds you are currently investing in. This should be easy to find on the website of your fund company or in the fund’s prospectus.
- For an estimate of how much you have paid in investment costs in the past year multiply the expense ratio of each fund by the current balance you have invested in each fund.
- Write down the expense ratio of each fund and keep it handy, as we will use it again later.